At the heart of it most scams are very simple—Satyam was no different. Sometime in 2003, B Ramalinga Raju, the founder and chairman of Satyam Computer Services started over-declaring revenues of the company. The process continued till 2008. On January 7, 2009, Raju in a letter to the board of directors of the company admitted to fudging the accounts of Satyam. Between 2003 and 2008, Raju over-declared revenues of the company by creating fictitious clients. Once he had over-declared revenues he automatically ended up over-declaring profits. Over-declared profits had to be invested somewhere. This led to the creation of fictitious bank statements and fixed deposit receipts. With a rapid advancement in the quality of colour printers, creating fictitious bank statements wouldn’t have been very difficult. In his letter to the board, Raju admitted that the cash and bank balances were hugely overstated. The cash and bank balances of the company as on September 30, 2008(the last time the company declared quarterly results) were at Rs 5,313 crore. Th actual number was at a much lower Rs 273 crore. More than half a decade of declaring fictitious profits had led to a massive jump in the cash and bank balances of the company. But the number, like the profits of the company, was fictitious. The company was guzzling whatever “real” cash it had at a very fast rate. By the time January 2009 started, the company’s actual cash and bank balance of the company would have been much lower than Rs 273 crore. One of the theories put forward after Raju admitted to all the wrongdoings in the letter was that only when he realized that the company wouldn’t have enough money to keep paying salaries to its employees did he decide to come out with the truth. As Raju said in his letter: “The company had to carry additional resources and assets to justify higher level of operations…It was like riding a tiger, not knowing how to get off without being eaten.” The irony is that Raju had to get off the tiger, and he still hasn’t been eaten. Like all big businessmen in India, Raju is also a survivor. A special court in Hyderabad has found him and nine others guilty of cheating, criminal breach of trust, destruction of evidence and forgery. The court pronounced a seven year-jail term for the founder and also imposed a Rs 5 crore fine on him. It took the judicial system six years and three months to sentence Raju. And this is not the end of it. The decision will be challenged in higher courts and the process will continue for a while. The question I want to explore in this column is the timing of Raju’s confession. Raju sent a tell-all letter to the Satyam Board in January 2009. Why didn’t he do the same in January 2008? Or even earlier, for that matter, is a question worth asking. The probable reason is that Raju was confident enough of pulling off the scam till he wasn’t. And why is that? It is worth remembering that between 2003 and 2008, the stock market in India had a huge bull run. The economy was also booming. And in such a scenario, when the financial system is flush with money, it is easy to keep a scam going. As economic historian Charles Kindleberger writes in Manias, Panics and Crashes: “The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom.” This precisely what Ramalinga Raju was busy doing. The stock market started crashing from early 2008, due the advent of what we now call the global financial crisis. And because of this, money wasn’t as easy to raise as was the case earlier. Raju tried to plug the huge gap in Satyam’s balance sheet by buying out two real estate firms Maytas Properties and Maytras Infra. Both these firms were owned by his family (Maytas is the opposite of Satyam). But by late 2008, an era of easy money had come to an end. And sham transactions were not as easy to pull through. The idea here was to use Satyam’s fake cash and bank balances to buy out the real estate firms and thus have “real” assets on the balance sheet. As Raju wrote in the letter: “ The aborted Maytas acquisition deal was the last attempt to fill the fictitious assets with real ones…Once Satyam’s problem was solved, it was hoped that Maytas’ payments can be delayed.” But this deal fell through after the independent directors on the Satyam board raised issues about an IT company taking over real estate assets. In fact, if Raju had tried to push this deal through a year earlier, chances are that the board might have agreed, given that the going was good at that point of time. And when the going is good no one wants to spoil the party by asking inconvenient questions. As the economist John Kenneth Galbraith writes in The Great Crash 1929: “At any given time there exists an inventory of undisclosed embezzlement. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. In good times people are relaxed ,trusting, and money is plentiful. … Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. … Just as the (stock market boom) accelerated the rate of growth (of embezzlement), so the crash enormously advanced the rate of discovery.” Interestingly, the Satyam scam was the first of many scams that were to hit the nation starting in 2009. It was followed by the 2G, Commonwealth games and the coalgate scam. Sahara, Saradha, Rose Valley and many other big Ponzi schemes came to light. The National Spot Exchange scam came to light as well. These scams were mostly executed during the period between 2003 and 2008, when the economy was doing well and the stock market was going from strength to strength, but they were only revealed after the good days came to a stop. In that sense Raju set the trend of things to come. We have to give him credit for at least that.
(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)
In Ek Thi Daiyan, the latest horror flick to come out of Bollywood, the dying daiyan (witch) says something to the effect of “main wapas aaongi (I’ll be back).” Ponzi schemes are a tad like that. They keep coming back one after the other. Only sometime back we were talking about the Stockguru Ponzi scheme. Before that the emu ponzi scheme and Speak Asia had been in the news. More recently the MMM Ponzi scheme and Saradha chit fund have taken up a lot of news space. MMM India recently put itself into what it calls a calm regime where operations like money transfer will remain suspended and hence those who have put money into the scheme won’t be able to withdraw it. The Saradha Chit fund has collapsed. The question is why do Ponzi schemes keep occurring over and over again in India? A popular explanation is that India is an under-banked country and that gets people to invest in Ponzi schemes rather than deposit money in the bank. As The Economic Timespoints out in an editorial “the repeated sprouting of dubious Ponzi schemes across the country points to a failure of the formal saving and banking system.” This maybe true to some extent but does not really explain why Ponzi schemes keep cropping up all the time and why people invest in them. Take the case of MMM India Ponzi scheme. To participate in it, an individual needed to have a bank account. To be a part of Speak Asia an individual had to participate in two online surveys per week. An individual who has access to an online connection is more than likely to have a bank account as well. So Ponzi schemes are not just about India having fewer banks. There is a clear mental dimension at play which makes individuals invest in Ponzi schemes over and over again. And this makes sure that there are always scamsters looking to cash in. Robert Shiller, an economist, defines a Ponzi scheme in a research paper titled From Efficient Market Theory to Behavioural Finance as follows: A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors. It creates a false perception of high returns for initial investors by distributing to them money brought in by subsequent investors. Initial investor response to the scheme tends to be weak, but as successive rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. Finally, the scheme collapses when new investors are not prepared to enter the scheme. The phrase to mark in this definition is “high returns generate excitement”. Very recently, MMM India promised returns of 100% per month to prospective investors. The prospect of high returns pushes individuals to take on the risky bet of investing in a Ponzi scheme. As Robert Shiller writes in Finance and the Good Society“The mere presence of uncertainty in a positive direction creates a pleasurable sensation (in the brain), and so the reward system creates an incentive to take on risky positive bets…This human tendency also helps explain why people like to gamble, and why many people will return every day to bet a small sum in a lottery. It also helps explain why people are willing to speculate aggressively on investments.” This gets individuals to invest in a Ponzi scheme. And after one lot of investors has invested in a Ponzi scheme it tends to take on a life of its own. The initial lot of investors then become the advertisers for the scheme. If a person wants to invest, the chances are he will look around to see what his acquaintances, neighbours or relatives are doing with their money. If the people around the potential investor invest in a certain way, there might be a tendency for him to follow them. Much like the ‘circular mills’ of ants. The mill is created when an army of ants find themselves separated from their colony. Once they are lost they obey a simple rule: Follow the ant in front of you. Decisions of investors, much like the circular mills of the ants, are not made at the same time but in a sequence. People who invest in the Ponzi Scheme assume that the scheme is a good bet simply because some of the people they know have already invested in it. So everyone ends up making the wrong decision because the initial investors get into the scheme by chance. This happens because the attraction of easy money is something that investors cannot resist. Ponzi Schemes offer the prospect of huge returns in a short period of time vis a vis other investments available in the market at that point of time. Greed also results when investors see people they know make money through the Ponzi Scheme. As Charles Kindleberger wrote in Manias, Panics and Crashes “There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”. Overconfidence also has a part to play. Most people are confident that they won’t become victims of financial frauds. This also leads them to invest in Ponzi schemes. Ove rconfidence is also at play when investors understand that they are getting into a Ponzi scheme, but they are still willing to enter the scheme, because they feel that some greater fools could be depended on to enter the scheme after they have and this would give them handsome returns on their investments. The contract effect is also at play. It becomes relevant in the context of a Ponzi Scheme when the prospective investor starts comparing the returns on the various other investment avenues available in the market for investment at that point of time. The high returns of offered by a Ponzi scheme stand out clearly and attracts investors. So a Ponzi scheme just doesn’t spread only because of a weak banking structure though that might be true in case of Sahara or even Saradha chit fund. Also it is important to remember the first sentence in Shiller’s definition of a Ponzi scheme, which is: “A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors.” So people running Ponzi schemes spend a lot of time in building a ‘supposed’ business model and building a great brand. The Saradha chit fund had built a huge media empire in West Bengal. It had also purchased a motorcycle company, to give some semblance of a business model to its investors. Sahara is similarly into a lot of businesses and even sponsors the Indian cricket team. Similarly, Speak Asia was in the magazine and survey business. It also advertised majorly in the publications of The Times Group, to build credibility. Emu Ponzi schemes were in the business of rearing and selling emus. And Stockguru helped investors make money by investing in stocks. MMM, in its original Russian avatar, sponsored the Russian football team in the 1994 football worldcup. When questions were raised about the huge returns, it had promised, MMM stated that it had solid investments, but did not want to disclose them as its competitors might imitate its investment strategy. Over the years, investors have been fooled into investing their money into Ponzi Schemes which keep appearing in various forms. They ignore the most fundamental principle of investment theory: You cannot expect to make large profits without taking risk. Whenever a large amount of money is at stake, individuals should logically seek large amounts of information on where they should invest. But most investors do not do so. Few ask the right questions at the right time and are naïve enough to believe in what is communicated to them by the people carrying out the fraud. Indeed, many Ponzi Schemes do not get reported as people do not like to admit that they have been fleeced because of their greed. The ones, which are reported and investigated, get stuck in the quagmire of our legal system. This encourages more people to run Ponzi Schemes. And every time a Ponzi scheme is exposed, the confidence of the investor in the financial system goes down. The most commonly suggested solution for prevention of Ponzi Schemes is sharing more and more information with the investing public. But research in psychology shows that more information does not necessarily improve judgement. Any extra information is helpful only if it comes without any bias. But that is rarely the case. Moreover, the ability of the common man to assimilate information is limited. Rather than assuming investors are knowledgeable about investment opportunities, the best solution to the problem of Ponzi schemes might be ensuring swift legal mechanisms to punish the unscrupulous masterminds behind the Ponzi Schemes. This will ensure that every prospective fraudster will think twice before launching another Ponzi scheme.
The article originally appeared on www.firstpost.com on April 23, 2013
Vivek Kaul So a Ponzi scheme is in the news again. Last time it was the emu Ponzi scheme. Before that there was Speak Asia. Now it’s the turn of Stock Guru to take investors across the county for a ride. The modus operandi as is the case with all Ponzi schemes is the same: the lure of high returns. In the end more than the frauds who ran Stock Guru it’s the investors who invested in the scheme have only themselves to blame. There greed did them in. While one Ponzi scheme differs from another, but despite the details changing, the structure abides. Let’s first try and understand what exactly is a Ponzi scheme and why is it so called. Charles Ponzi Chalres Ponzi was an Italian immigrant who landed in America in 1903. Sometime in August 1919, in the process of starting an export magazine, he realised that there was money to be made through an arbitrage opportunity that existed. Ponzi sent an offer to a person in Spain requesting him to subscribe to the magazine. The subscriber agreed and sent Ponzi an international postal reply coupon. This coupon could be exchanged at the post office for American stamps which would be needed to send the magazine to the Spanish subscriber. The coupon in Spain cost the equivalent of one cent in American currency. In America when Ponzi exchanged the coupon, he got six cents worth of stamps. And this set Ponzi thinking. What was the plan? The plan was very simple. Ponzi could buy international postal reply coupons convert them into American stamps and sell those stamps and make money. So he would need one cent to buy an international postal reply coupon in Spain. That coupon could be exchanged for stamps worth six cents in America and those stamps could then be sold for six cents. Hence there was a clear profit of five cents, assuming there were no other charges, to be made on every one cent that was invested. The trouble of course was that Ponzi needed money to get started. Double your money in 90 days So Ponzi launched an investment scheme asking people to invest. He promised them that he would double their money in 90 days. Ponzi would make a profit of five cents for every one cent that he invested. That meant a profit of 500%. As far as investors were concerned he was only promising to double their money and that meant a return of 100%. Hence, on the face of it looked like a reasonably safe proposition. At its peak, the scheme had 40,000 investors who had invested around $ 15 million in the scheme. What went wrong? As if often the case what sounds great in theory cannot be put into practise. The idea was brilliant. But Ponzi had not taken into account the difficulties involved in dealing with various postal organizations around the world, along with other problems involved in transferring and converting currency. Also with all the money coming in Ponzi couldn’t stop himself from living an extravagant life and blowing up the money investors brought in. But soon doubts started arising on the legitimacy of the scheme. The Boston Post newspaper ran a story on July 26, 1929, and within a few hours, angry depositors lined up at Ponzi’s door, demanding their money back. Ponzi settled the obligations of the people who had gathered. The anger subsided, but not for long. On Aug 10th, 1920, the scheme collapsed. It was revealed that Ponzi had purchased only two international postal reply coupons and was using money brought in by the new investors to pay off old investors. So what is a Ponzi scheme? Robert Shiller, an economist at Yale University in the United States defines Ponzi schemes as “A Ponzi Scheme involves a superficially plausible but unverifiable story about how money is made for the investors and the fraudulent creation of high returns for initial investors by giving them money invested by subsequent investors. Initial investor response to the scheme tends to be weak, but as the rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. ( Adapted from Shiller 2003).” Hence, a Ponzi scheme is essentially a fraudulent investment scheme where money brought in by the newer investors is used to pay off the older investors. This creates an impression of a successful investment scheme. Of course as long money entering the scheme is greater than the money leaving it, all is well. The moment the situation is reversed, the scheme collapses. This kind of financial fraud happened even before Ponzi’s name came to be attached to it. And it continues to happen more than ninety years after Charles Ponzi ran his scam. Any Ponzi Scheme will differ from another Ponzi Scheme. But if one may borrow a French phrase, Plus Ca Change, Plus C’est La Meme Chose, the more things change, the more they remain the same. The details might change from scheme to scheme, but the structure abides. Here are some characteristics of Ponzi schemes. The instrument in which the scheme will invest appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors. In case of the emu Ponzi scheme an investor was supposed to rear emus and then sell their meat, oil etc. In order to become a member of Speak Asia one had to invest Rs 11,000. This investment was for subscribing to the electronic magazine issued by the company called “Surveys Today”. This also allowed the member to participate in two online surveys every week and make Rs 500 per survey or Rs 1000 per week. This when converted into a yearly number came to Rs 52,000 (Rs 1000 x 52). So an investment of Rs 11,000 ensured that Rs 52,000 was made through surveys, which meant a return of 373% in one year. And this was basically the main selling point of the scheme. So the business model of the company was pretty vague. The legal advisor of the company Ashok Saraogi said at a press conference “The company is not selling any surveys to panellists but e-zines (electronic magazines) to its subscribers. Surveys are offered as additional benefit and can be withdrawn anytime if the company’s contract with clients comes to an end.” Stock Guru also worked along these lines. The company claimed to be making money by investing in stocks and had this to advise to its customers: “We advise our clients to buy shares at a low price and sell them at a higher price. Selecting the right share at the right price and entering the capital market at the right time is an art. We help all our clients to make huge profits by investing in good shares for very short/short/medium/long term depending upon the client’s requirements.” Very sane advise when it comes to investing in the stock market but nothing specific about how the company plans to help its clients make a huge profit. Most of the Ponzi Schemes start with an apparently legitimate or legal purpose. Let’s take a look at some of the Ponzi schemes of yore. Hometrade started off as a broker of government securities, Nidhis were mutually beneficial companies and Anubhav Plantations was a plantations company. They used their apparently legitimate or legal purpose as a façade to run a Ponzi Scheme. Same stands true for the present day Ponzi schemes. Speak Asia was in the magazine and survey business. Emu Ponzi schemes were in the business of rearing and selling emus. And Stock Guru helped investors make money by investing in stocks. The most important part of a Ponzi scheme is assuring the investor that their investment is safe. This is where the meeting of initial obligations becomes very important. Early investors become the most important part of the scheme and spread it through word of mouth, so that more investors invest in the scheme and help keep it going. Ironically enough, in many cases it is their own money that is being returned to them. Let us say an investor invests Rs.100 in a scheme that promises 20% return in 60 days. So Rs.20/- can be paid out of investor’s own money once every two months up to ten months. The Ponzi scheme can keep going by essentially returning the investor his own money. Speak Asia did this by returning around Rs 250 crore to the investors from the Rs 2000 crore it had managed to collect. This gave the scheme a greater legitimacy. Stock Guru also worked along similar lines. As an article in the Money Life magazine pointed out “You pay Rs10,000 as investment and Rs1,000 as registration fees. There is no limit on the maximum amount one can invest. Stockguruindia.com offered a return of 20% per month for up to six months and the principal amount invested is returned in the next six months. It also gave post-dated cheques of the principal and a promissory note as security.” As a story in The Times of India points out “People invested between Rs 10,000 and Rs 60 lakh at one go in Stock Guru India as Ulhas promised to double their capital…He (i.e.Ulhas Khaire who ran the scam) also returned money to some investors to win their trust so that they would recommend Stock Guru to others,” said an officer. In fact this initial lot of investors become brand ambassadors and passionate advocates of the scheme. When this writer wrote about Speak Asia being a Ponzi scheme he got stinkers from a lot of people who had invested their money in Speak Asia at the very beginning and made good returns. The rate of return promised is high and is fixed at the time the investor enters the scheme. So the investor knows in advance what return he can expect from the scheme. The promised returns were substantially higher compared to other investment avenues available in the market at that point of time. The rate of return was also fixed in advance. So there was no volatility in returns as is in other forms of investment. This twin combination of high and fixed returns helps in attracting more and more investors into the scheme. In Speak Asia the investor knew that he would get paid Rs 1000 per week for conducting surveys. And by the end of the year he would earn Rs 52,000 on an initial investment of Rs 11,000. In case of Stock Guru a minimum of Rs 10,000 was to made as an investment. And Rs 1,000 was the registration charge. The company promised a return of 20% per month against the investment for the first six months. For a person investing Rs 10,000 that would mean a return of Rs 2,000 per month or Rs 12,000 after the first six months. The principal amount of Rs 10,000 would be returned over the next six months. Hence on an investment of Rs 11,000, a profit of Rs 12,000 was being made in a very short period of time. These were fantastic returns. Brand building is an inherent part of a Ponzi Scheme. MMM, a Russian Ponzi scheme marketed itself very aggressively. In the 1994 football World cup, the Russian soccer team was sponsored by MMM. MMM advertisements ran extensively on state television and became very famous in Russia. Hometrade also used the mass media to build a brand image for itself. It launched a high decibel advertising campaign featuring Sachin Tendulkar, Hrithik Roshan and Shahrukh Khan. When the company collapsed, the celebrity endorsers washed their hands off the saying that they did not know what the business of Hometrade was. Anubhav Plantations also ran a huge advertising campaign. Film stars also advocated investing in the emu Ponzi schemes. Speak Asia ran a huge ad campaign. The irony was it advertised extensively in newspapers which dealt with personal finance. Stock Guru did its level of brand building as well. As a report in the Times of India points out “ Ulhas Prabhakar Khaire andRaksha Urs, masterminds of the multi-crore Stock Guru fraud, would organize their promotional events in Macau, Malaysia, Mauritius and several other countries, taking only a few premium investors on expenses-paid trips, say Delhi Police sources. The events were reportedly organised regularly in five-star hotels, and Ulhas made all the arrangements, including booking flights for investors and celebrities. Ulhas is learnt to have named two Bollywood celebrities he invited to his promotional events.” All these things lead to people investing in these schemes. The attraction of easy wealth is something that investors cannot resist. Ponzi schemes offer huge returns in a short period of time vis a vis other investments available in the market at that point of time. With good advertising and stories of previous investors who made a killing by investing in the scheme, investors get caught in the euphoria that is generated and hand over their hard earned money to such schemes going against their common sense. Greed also results when investors see people they know make money through the Ponzi scheme. As economic historian Charles Kindleberger once wrote “ There is nothing so disturbing to one’s well being and judgment as to see a friend get rich.” Given this, even though a lot of questions can be asked they are not asked. Ponzi schemes have not been eliminated. This is sad because for the economy as whole, they are undesirable. The world has not learned from its experience. “Mundus vult decipi-ergo decipitaur-The world wants to be deceived , let it therefore be deceived ”. (Winkler 1933 as quoted in Kindlberger 2000). All Ponzi schemes collapse in the end once the money leaving the scheme becomes greater than the money entering it. Stock Guru was no different. To conclude, any investment scheme promising more than 15% return a year has to be a very risky proposition. It may not always be a Ponzi scheme, but the chances are that it is more often than not. The article originally appeared on www.firstpost.com on November 15, 2012. (Vivek Kaul is a writer. He can be reached at [email protected])